Reconciling the Irreconcilable Earnings and Profits in Cross-Border Separations

Transcription

1 Reconciling the Irreconcilable Earnings and Profits in Cross-Border Separations Bloomberg BNA Corporate Taxation Advisory Board 16 January 2014 Devon M. Bodoh KPMG LLP J. Brian Davis Ivins, Phillips & Barker Chtd.

2 Agenda Background Allocation of E&P in corporate separations Corporate separations involving a CFC Proposed regulations impacting allocation of E&P in cross-border corporate separations Policy issues 2

3 Background

4 Background Significance of E&P Earnings and profits (E&P) is primarily relevant for determining whether a distribution from a corporation to its shareholders is taxed as a dividend It is a shareholder relevant attribute If the amount of the distribution exceeds the corporation s E&P, the excess is treated as a return of basis (to the extent of such basis) and then as an exchange of stock subject to taxation as a capital gain 4

5 Background Significance of E&P (cont.) In the international context, E&P is also used to determine the taxation of dispositions of the stock of foreign corporations under sections 367(b) and 1248 The purpose of these provisions is to ensure previously untaxed E&P of a controlled foreign corporation (CFC) is taxed in the US Dispositions of a foreign corporation s stock governed by these two provisions may result in income that is taxed as a dividend depending on the CFC s E&P 5

6 Background Tax-Free Separations Under Section 355 Section 355: Basic tax-free corporate separation requirements Non-tax business purpose Active trade/business conducted by both distributing and controlled At least 80% voting power and at least 80% total number all other classes of controlled held by distributing immediately prior to distribution and is distributed in separations Separation not a device for distribution of E&P of distributing or controlled Certain continuity requirements satisfied Section 355(d) distribution is not a disqualified distribution Section 355(e) no prohibited 50%-or-greater acquisitions of stock of distribution or controlled in connection with separation Section 355(g) neither distributing nor controlled is a disqualified investment company 6

7 Background Tax-Free Separations Under Section 355 (cont.) SH Distributing Spin off If Distributing s distribution of stock of Controlled to Distributing s SH (a spin-off) satisfies the requirements of Section 355, the following US fed. income tax consequences are expected to occur: Controlled SH No gain / loss to Distributing on distribution of Controlled stock No income to Distributing s SHs on receipt of controlled stock Distributing s SHs stock basis in Distributing allocated between Distributing and Controlled stock Distributing s E&P allocated between Distributing and Controlled Distributing Controlled Special rules may apply in cross-border context 7

8 Background Tax-Free Separations Under Section 355 (cont.) Tax-free corporate separations under section 355 generally take one of two general forms: A distribution of Controlled not preceded by a contribution of assets (Standalone 355 Transaction) A distribution of Controlled preceded by a contribution of assets from Distributing to Controlled under Section 368(a)(1)(D)/Section 355 (D/355 Transaction), further categorized where: Controlled is newly-formed Controlled is an existing subsidiary 8

9 General Allocations of E&P in Corporate Separations

10 General Allocations of E&P Background The section 312 regulations provide rules for adjusting the E&P of Distributing and Controlled in a corporate separation: D/355 Transaction Distributing s E&P generally allocated between Distributing and Controlled Standalone 355 Transaction Distributing s E&P is reduced and Controlled s E&P is potentially increased A deficit in E&P is never allocated to Controlled 10

11 General Allocations of E&P D/355 Involving Newco E&P allocation in a D/355 Transaction Controlled is Newco E&P is allocated proportionately between Distributing and Controlled based on the relative FMVs of their businesses immediately after the separation 11

12 General Allocations of E&P Ex. of D/355 Involving Newco FMV: $40 E&P: $60 $20 of D assets Distributing SH Facts Distributing Controlled SH Controlled stock Controlled Spin off of Controlled Prior to the transaction, Distributing s SH owned 100% of the stock of Distributing Distributing had $60 of E&P and business assets with FMV of $40 Step One Distributing forms Controlled by transferring business assets with a FMV of $20 to Controlled for Controlled stock in D-reorg Step Two Distributing distributes the Controlled stock to Distributing s SH in a spin-off Distributing s E&P allocated between Distributing and Controlled Analysis Since Controlled is a Newco, Distributing s E&P is allocated proportionately based on FMV of assets Thus, $30 of Distributing s E&P (50%) is allocated to Controlled; $30 remains with Distributing 12

13 General Allocations of E&P D/355 Involving Oldco E&P allocation in a D/355 Transaction Controlled is Oldco In a proper case, allocation shall be made between the distributing corporation and the controlled corporation in proportion to the net basis of the assets transferred and the assets retained or by such other method as may be appropriate. Treas. Reg. Section (a) Net basis the basis of the assets less liabilities assumed or liabilities to which such assets are subject This rule does not expressly provide which transactions it covers, and the scope of the term in a proper case is unclear The preamble to the proposed regulations under Section 367(b) (discussed later) takes the position that this regulation does not address the allocation of E&P in a D/355 Transaction involving an Oldco If this is true, what transactions does the in a proper case language refer to? 13

14 General Allocations of E&P Ex. of D/355 Involving Oldco SH Facts FMV: $20/$20 Basis: $10/$30 Starting E&P: $60 Starting FMV: $20 Starting Basis: $20 Starting E&P: $0 $20 of D assets Distributing Controlled SH Controlled stock Spin off of Controlled Distributing has two business assets (excluding the Controlled stock) with equal values of $20. Distributing contributes one of the assets, which has a basis of $10, to Controlled and retains other asset, which has basis of $30 Additionally, prior to transaction (i) Controlled has business assets with a value and basis of $20 (thus, the Controlled stock has a value of $20), (ii) Distributing has $60 of E&P, and (iii) Controlled has no E&P Analysis If this is the proper case requiring allocation based on net basis, $15 of the E&P is allocated to Controlled (25% or $10/$40) and the remaining $45 stays with Distributing If this is not the proper case, how is E&P allocated? FMV of the assets? Distributing Controlled Hybrid Approach (discussed later) under the proposed Section 367(b) regulations? 14

15 General Allocations of E&P Standalone 355 Transaction E&P allocation in a Standalone 355 Transaction Distributing The E&P of Distributing is decreased by the lesser of: The amount by which the E&P of the distributing would have been decreased if it had transferred the stock of Controlled to a Newco in a D/355 Transaction, or The net worth of Controlled (i.e., the sum of the basis of all of the properties plus cash minus all liabilities) Controlled if the E&P of Controlled immediately before the transaction is less than the amount of the decrease in E&P of Distributing (including a case in which Controlled has a deficit), the E&P of Controlled will be equal to the amount of the decrease. Otherwise, Controlled s E&P remains unchanged 15

16 General Allocations of E&P Ex. of Standalone 355 Txn. SH Facts FMV: $120 E&P: $100 Distributing Spin off of Controlled Prior to the transaction, Distributing s SH owned 100% of the stock of Distributing which has E&P of $100 and assets (not including the Controlled stock) with a FMV of $120 Assume Controlled s net worth is at least $25 Distributing owns 100% of the Controlled stock, which has a FMV of $40 and E&P of $15 FMV: $40 E&P: $15 Controlled Distributing distributes the Controlled stock to Distributing s SH Analysis SH Distributing s E&P is reduced by $25, which is the amount its E&P would have decreased if it had contributed the Controlled stock to a Newco ($40/$160 or 25%, multiplied by $100) Distributing Controlled Because Controlled s E&P is less than the amount of the reduction, its E&P is increased to $25 16

17 Separations Involving a CFC (Distributing or Controlled)

18 Separations Involving a CFC Generally Significance of E&P and CFCs Separations involving a CFC have the potential to terminate a CFC s status as a CFC (generally in a non-pro rata distribution) Separations involving a CFC may bail out previously untaxed E&P of Distributing to Controlled and potentially shift such earnings outside of the US tax system 18

19 Separations Involving a CFC Section 1248 General Rule If a US person owns more than 10% of the voting stock of a foreign corporation at any time during the 5-year period (ending on the date of the sale) when the foreign corporation was a CFC, gain recognized on the sale or exchange of such stock is treated as a deemed dividend to the extent of the foreign corporation s E&P attributable to such stock 19

20 Separations Involving a CFC Where Distributing is a CFC The section 367(b) regulations contain a regime for ensuring untaxed E&P is taxed in the US with regard to certain corporate separations involving a CFC If a CFC distributes either US or foreign Controlled stock in a tax-free separation under section 355 The distributee shareholder compares pre- and post-distribution Section 1248 Amounts (defined below) as to stock of the distributing CFC and, if applicable, the foreign Controlled To the extent the distribution causes a reduction in the Section 1248 Amount of the relevant CFC, the distributee makes basis adjustments and/or has income inclusion (i.e., deemed dividend) There are different calculations for spin-offs (pro rata) and split-offs (non-pro rata) distributions 20

21 Separations Involving a CFC Relevant Definitions Relevant sections 1248 and 367(b) definitions Section 1248 Amount net positive E&P that would have been includible in income as a dividend under section 1248 if the stock was sold by the SH Pre-Distribution Amount Distributees Section 1248 Amount computed immediately before the distribution, but only to the extent attributable to Distribution and/or Controlled (as applicable) Distributing s Pre-Distribution Amount determined on stand-alone basis Post-Distribution Amount Distribtuee s Section 1248 Amount with respect to Distributing and/or Controlled stock (as applicable) computed immediately after the distribution 21

22 Separations Involving CFCs Ex. Spin-Off FMV: $250* E&P: $0* FMV: $250* E&P: $300* CFC FD FMV: $200 Basis: $80 CFC USS FD FC SH 40% FC * Computed on stand-alone basis Spin off of FC Facts USS owns 40% of stock of FD (a CFC) FD owns 100% of FC USS has a $80 basis in its FD stock, which has FMV $200 On stand-alone basis, FD has FMV of $250 and E&P $0 On stand-alone basis, FC has FMV of $250 and E&P $300 FD makes pro-rata distribution of FC stock USS receives FC stock worth $100 (i.e., 40%) Application in respect of FC Pre-distribution Section 1248 Amount: $120 If USS had sold its FD stock, it would have recognized $120 gain, all of which would have been treated as a dividend under section 1248 and all of which attributable to FC s E&P Post-distribution Section 1248 Amount: $60 Value of FC stock received: $100 Post-distribution basis in FC stock: $40 Deemed dividend under section 1248 if FC stock sold: $60 USS must reduce its basis in FC stock from $40 to $0, and include $20 in income as a deemed dividend 22

23 Separations Involving CFCs Ex. Spin-Off (cont.) FMV: $250* E&P: $0* FMV: $200 Basis: $80 CFC USS FD 40% Spin off of FC Application in respect of FD Pre-distribution Section 1248 Amount: $0 Post-distribution Section 1248 Amount: $0 Although USS would recognize gain if it sold its FD stock, no gain would be treated as a dividend under section 1248 (since FD has no E&P attributable to it) FMV: $250* E&P: $300* FC Since the amounts are the same, no deemed dividend or basis reduction USS increases its basis in FD stock by $60 (i.e., basis reduction and deemed dividend with respect to FD stock) SH CFC FD FC * Computed on stand-alone basis 23

24 Separations Involving CFCs Ex. Split-Off US1 US2 Facts 50% 50% FMV: $750 Basis: $500 US1 and US2 each own 50% of FD (a CFC), worth $750/ea Both US1 and US2 have a $500 basis in their shares FMV: $750* E&P: $0* CFC FD Split off of FC On stand-alone basis, FD has a FMV of $750 and $0 E&P On stand-alone basis, FC has a FMV of $750 and $500 E&P FMV: $750* E&P: $500* FC In a non-pro rata distribution, FD distributes the FC stock to US2 in exchange for its FD stock Application in respect of US1 FC stock Pre-distribution Section 1248 Amount: $250 Post-Distribution Section 1248 Amount: $0 US1 US2 US1 must include $250 in income as a deemed dividend Unlike pro-rata distribution, no basis adjustment FD stock CFC FD FC * Computed on stand-alone basis Pre-Distribution Section 1248 Amount: $0 Post-Distribution Section 1248 Amount: $0 No deemed dividend. US1 increases basis in FD stock by $250 24

25 Separations Involving CFCs Ex. Split-Off (cont.) US1 US2 Application in respect of US2 50% 50% FMV: $750 Basis: $500 FC stock Pre-distribution Section 1248 Amount: $250 FMV: $750* E&P: $0* CFC FD Split off of FC Post-Distribution Section 1248 Amount: $250 (i.e., amount of gain treated as a deemed dividend if US2 had sold FC stock immediately after) Since no difference, no deemed dividend FMV: $750* E&P: $500* FC FD stock Pre-Distribution Section 1248 Amount: $0 Post-Distribution Section 1248 Amount: $0 Since no difference, no deemed dividend US1 US2 CFC FD FC * Computed on stand-alone basis 25

26 Proposed Regulations Impacting E&P Allocation in Cross-Border Separations

27 E&P Allocations in CB Section 355s Generally The current final regulations under section 367(b) related to a separation involving either a foreign Distributing or a foreign Controlled mandate an income inclusion that is dependent on the allocation of E&P in a cross-border separation. These regulations do not otherwise modify the application of the section 312 regulations The preamble to these regulations state that forthcoming proposed regulations will more fully consider the allocation of E&P in section 355 distributions where either (or both) the distributing or controlled corporation is a foreign corporation. It further provides that [u]ntil the IRS and Treasury promulgate such regulations, taxpayers should use a reasonable method (consistent with existing law and taking proper account of the purposes of the foreign tax credit regime) to determine the carryover and separation of [E&P] and related foreign taxes. TD 8862 (Jan. 2000) In late 2000, proposed regulations on E&P were issued. See REG (Nov. 2000) Despite somewhat recent activity in the area, the 2000 proposed regulations on E&P have not been updated. See, e.g., TD 9273 (Aug. 2006) ( The Treasury and the IRS believe that relevant cross-border tax consequences of section 355 transactions [(e.g., E&P)] should be dealt with in a separate guidance project. ) 27

28 E&P Allocations in CB Section 355s 2000 Proposed E&P Regs. Prop. Treas. Reg. Section 1.367(b)-8 As noted earlier, proposed regulations under section 367(b) were issued in 2000 relating to the allocation of E&P in a cross-border separation where either or both Distributing or Controlled are foreign corporations (2000 Proposed E&P Regulations) The 2000 Proposed E&P Regulations confirm that section 312 regulations generally apply to corporate separations involving a foreign Distributing or Controlled, but modify the application of the section 312 regulations For instance, allocations of E&P in both a D/355 Transaction and a Standalone 355 Transaction use net basis (not FMV) for making calculations 28

29 2000 Proposed E&P Regs. D/355 Transactions In a D/355 Transaction involving Oldco Controlled, E&P is allocated using the following Hybrid Approach Distributing s E&P is reduced by the sum of (a) the reduction relating to the assets transferred in the D/355 Transaction, and (b) the reduction that would occur relating to the assets held by Controlled prior to the D/355 Transaction In this scenario, Controlled s E&P is increased only by the amount of the reduction in (a) above 29

30 2000 Proposed E&P Regs. Ex. of D/355 Txn. with Oldco SH Facts FMV: $20/$20 Basis: $10/$30 Starting E&P: $60 FD Spin off of FC FD has two business assets (not including the FC stock) with equal values of $20. FD contributes one of the assets, which has a basis of $10, to FC (an oldco) and retains the other asset, which has a basis of $30 $20 of FD assets FC stock Additionally, prior to transaction (i) FC has business assets with a value and basis of $20 (thus, the FC stock has value of $20), (ii) FD has $60 of E&P, and (iii) FC has no E&P Starting FMV: $20 Starting Basis: $20 Starting E&P: $0 FC Analysis Under the 2000 Proposed E&P Regulations, FD s E&P would be reduced by $35, which is the sum of: SH $10 the reduction that would occur under Treas. Reg. Section (a) relating to the assets transferred in the D/355 and FD FC $20 the reduction that would occur under Treas. Reg. Section (b) relating to the assets held by FC ($20/$60 (33%) multiplied by $60) FC s E&P would only be increased by $10 30

31 2000 Proposed E&P Regs. Standalone 355 Transactions In a Standalone 355 Transaction E&P is dealt with as follows Distributing s E&P must be reduced by the decrease in E&P that would have occurred if Controlled was transferred to a Newco in a D/355 Transaction Controlled s E&P is not increased under any circumstances 31

32 2000 Proposed E&P Regs. Ex. of Standalone 355 Txn. SH Facts FD has owned 100% of FC stock more than 5 years FMV: $60 Net Basis: $60 E&P: $60 FD Spin off of FC The FC stock owned by FD is worth one-half of the FMV of FD s net assets FD s basis in FC stock is $30 or one-half of the net basis of all of FD s assets (including FC stock) FMV: $30 Net Basis: $60 E&P: $60 FC Each of FD and FC has $60 of E&P and the net basis of FC s assets equals or exceeds $60 Analysis SH Under the 2000 Proposed E&P Regulations, FD s E&P would be reduced as if FC were transferred to a Newco in a D/355 Transaction Accordingly, FD s E&P is reduced proportionately based on the net basis of the assets of FC and the net basis of all of the assets of FD. In this case, FD s E&P reduction would be $30 FD FC However, FC s E&P would not be increased, and thus remains $60 32

33 Policy Issues

34 Policy Issues Generally Authority regarding E&P allocations in corporate transactions, particularly in corporate separations under section 355, historically focuses on anti-abuse (i.e., ensuring that a transaction does not prevent the taxation of E&P) The Treas. Reg. Section approach generally reduces Distributing s E&P but only increases Controlled s E&P in certain circumstances (this limited increase generally is to prevent the duplication of E&P) For example, in a Standalone 355 Transaction, the decrease in Distributing s E&P does not necessarily coincide with an increase of the same amount in Controlled s E&P Thus, there is the potential for a bail-out of Distributing s E&P 34

35 Policy Issues 2000 Prop. E&P Regs. & Immediate Income The 2000 Proposed E&P Regulations attempt to rectify the continued bail-out problem by causing an immediate income inclusion to a CFC s section 1248 shareholders Under the 2000 Proposed E&P Regulations, as described in the Hybrid Approach and Standalone 355 Transaction examples above, a portion of Distributing s E&P disappears and results in an income inclusion of such reduction under section 367(b) s mechanism of using Section 1248 Amounts 35

36 Policy Issues Appropriateness of Income Inclusion The 2000 Proposed E&P Regulations immediate income inclusion is a severe and broad penalty, especially with regard to non-abusive transactions This immediate income inclusion occurs even in transactions where the section 1248 shareholders have not reduced their interest in a CFC Such section 1248 shareholders arguably would still be subject to tax on the previously untaxed E&P Thus, any allocation of E&P should reflect this future taxation and defer a recognition of income until such a shareholder s interest in the untaxed E&P has been eliminated 36

37 Policy Issues Alternative Approach Even in a regime where Distributing s E&P continues to be reduced without a commensurate increase to Controlled s E&P, there are less harsh solutions to solve the bail-out problem For example, a reduction of a section 1248 shareholder s basis in Distributing s stock similar to the mechanism used to adjust basis when there is a reduction in a section 1248 amount (without the attendant income inclusion) Such an approach preserves the ability to tax a CFC s E&P while deferring recognition to a more appropriate recognition event 37

38 Circular 230 Disclaimer This document was not intended or written to be used, and cannot be used, for the purpose of avoiding US federal, state or local tax penalties 38